By Gene Russell, Manex President and CEO

I’ve been writing strategy and financial plans for forty years. From the big one, AT&T, down to my various start-ups and turnarounds. In this blog, I want to talk about my favorite metric from those years of experience and fun.

The business model is the most fundamental element that owners and C-levels must understand comfortably and deeply. Describing your product, who you sell to, why they buy, and how you maintain market share is illustrative of what you do. However, the true business model is the financial underpinnings of that description. One of the first and most important items is at the top of your P&L statement and its gross margin or gross profit margin. It’s foundational to what you can and cannot do in your business. In manufacturing, if you can increase the gross orofit margin through operational excellence and have the products that sell at a maximum market price – you probably are golden and pretty darn happy.

Gross Profit Margin Explained

Gross profit margin is a good metric for measuring how effective a company is at converting goods, materials and direct labor into profit, because it includes only the variable and fixed costs associated with producing or acquiring products and services. It also provides a measure of profitability that is independent of sales volume: if sales increase by a factor of two and cost of sales increases at the same rate, gross profit margin will remain the same.

Organizations can also use the gross profit margin formula to assess the margin of individual products or lines of business by performing the same calculation but inputting the revenue and costs specifically related to those products or business units.

What Does Gross Profit Margin Tell You & Why Is It Important?

Gross profit margin is a good yardstick for measuring how efficiently companies make money from products and services, because it measures profit as a percentage of sales revenue. It can therefore be used to more easily compare companies with different sales revenues.

Gross profit margin is sometimes used as an indicator of how well a company is managed. High gross profit margins suggest that management is effective at generating revenue based on the labor and other costs involved in generating its products and services. Big changes in gross profit margin quarter-over-quarter or year-over-year can sometimes indicate poor management. Other problems that could cause fluctuations in gross profit margin include temporary manufacturing issues that result in lower product quality and a higher level of product returns, reducing net sales revenue.

When gross profit margin declines steadily over time, the company may need to make adjustments to facilitate growth. For example, it may need to look for ways to sell a greater volume of products to compensate for declining profitability. Or this could be a sign that it should consider changing its business model, improving its manufacturing processes to make products more efficiently, or cutting costs in other ways. Alternatively, it may be undervaluing its products and may need to carefully raise prices. In many cases, it rode the product too long in the market without changes, improvements or a completely new version.

What Is a “Good” Gross Profit Margin? Should It Be High or Low?

A company should target as high gross profit margin as the market will support. Besides driving more profit to the bottom line (net income), a high gross profit margin leaves more money to invest in R&D and other activities that support long-term growth.

The Definition of a “Good” Gross Profit Margin Depends on the Industry in Which a Company Operates.

We use multiple industry studies to benchmark companies and provide background on all financial ratios, labor costs, revenue per employee, and other interesting metrics related to the business model. IBIS World Reports for example, produces studies only related to U.S. manufacturing companies, so the comparisons are very valid. These reports are provided to Manex through the NIST MEP program. One more advantage of dealing with Manex.

Advantages and Disadvantages of Using Gross Profit Margin

• It’s a quick method for showing the margin on the company’s products and lines of business.
• It can also serve as a barometer of a business’s management or sales organization.
• It provides a benchmark for comparing a company’s performance with competitors.
• It can highlight areas with opportunities for improvement—for example, if one product or service has higher gross profit margins than others, that could point to an opportunity to reduce COGS or shift the sales strategy for other product lines.
• It can be used to help set pricing at a competitive level while ensuring products are still profitable.

However, gross profit margin does have some limitations:

• It doesn’t show a company’s overall profitability because it doesn’t include all costs.
• Without proper context, it may present an inaccurate view of profitability. For example, a company may need to pay more for raw materials temporarily if several suppliers in a certain region close after a flood, or it may discount heavily in order to capture market share.
• It is less valuable for comparing companies across different industries. Average gross profit margin varies by industry sector, largely because of differences in COGS.

Gross Profit vs. Net Profit Margin

While gross profit margin is a useful financial metric, net profit margin is the true measure of a company’s overall profitability.

Net profit margin differs from gross profit margin in that it includes all the company’s expenses and costs, while the latter only includes COGS. However, I always start at what I consider the source of most pain and misunderstanding and that is the gross margin. If you think about it – there’s no positive net income unless your gross margin is driving that down to the rest of the P&L. In manufacturing, the difficult fix is not in admin and overhead or sales. It is on the floor in costs, and in the market in pricing.

To put it simply; If you don’t review your gross margin on a regular basis: On orders, during deal discussions, on contracts, and then on your P&L,  you’re not paying attention to the most important business model financial ratio you have in terms of daily, weekly, monthly and yearly success. EBTIDA?  Sure, that’s important – but first things first.